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Interest rates, the Australian economy and the latest share wobble

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Key points

  • The latest rise in interest rates and the surging Australian dollar (A$) should lead to some moderation in Australian economic growth, but it is still likely to remain reasonably solid.
  • The US slowdown, credit squeeze and strong A$ should head-off more rate hikes but the risk is on the upside.
  • Share market investors should expect continued volatility but the trend is likely to remain up.

The Reserve Bank of Australia’s (RBA) decision to raise the cash rate by another 0.25% to 6.75% came as no surprise after the stronger-than-expected rise in September quarter underlying inflation and a continuing run of strong economic data. This is the tenth 0.25% rate rise in the current cycle of increases that began in May 2002. However, coming on the back of high anxiety about the US economy the latest increase naturally adds to uncertainty about the outlook for the Australian economy and shares.
Rising interest rates and the Australian economy
Over the last decade the Australian economy has been extremely resilient having remained relatively unscathed during the Asian crisis, the tech wreck, the deflation of the east coast housing bubble and the worst drought in generations. Apart from rising mortgage arrears in some areas, there is little evidence that rising interest rates have had much of a negative impact either. The relative stability of the Australian economy reflects a whole range of factors including increased economic flexibility, sound economic management and good luck. However, the resilience of households in the face of numerous interest rate hikes despite household debt servicing costs reaching record levels has certainly come as a surprise.

While housing construction remains soft, retail sales remain robust, car sales are running at record levels and business investment is strong. As a result, after a two year soft patch gross domestic product (GDP) growth is running at around 4% again. There are several reasons for this recent resilience.

  • National income has received a significant and ongoing boost from higher commodity prices.
  • This, along with labour market reforms and 16 years of reasonably steady growth, has helped push the unemployment rate down to a 33-year low ensuring that growth in household income has remained strong.
  • Tax cuts and other spending initiatives have offset the impact of higher interest costs and petrol prices.
  • Most of the rise in household debt has been amongst older higher households borrowing to buy investment properties, shares or to trade up to better houses. This means that the first chart showing a massive rise in household income payments relative to household interest payments is less meaningful.

The increase in the number of older, higher income households with housing debt has meant that of those households with housing debt, the median debt servicing ratio is not much different than a decade ago.

In other words, the rise in household debt levels largely reflects an increase in the number of households with debt rather than debt per household. Older higher income households tend to be relatively insensitive to interest rate increases. As a result, the rise in interest rates over the last few years has not been nearly as negative for the economy as might have been surmised from the rise in aggregate debt levels alone.

  • Only about a third of households have mortgages and of these about 20% are fixed. So it’s only about 26% or so of households in total which are directly adversely affected by higher interest rates.

Australian economic outlook – more of the same
While the latest interest rate increase combined with the strong A$ may help dampen growth, overall economic growth is likely to remain reasonable going forward.

  • Tax cuts and cash payments to households are continuing to offset the impact of higher interest costs and going by election promises from both sides of politics, this looks like remaining the case going forward. At current household debt levels, each 0.25% interest rate hike costs the Australian household sector about an extra A$2.5 billion (bn) each year in higher interest payments. Yet against this, the household sector will receive an extra A$7.5 bn in tax cuts and Government handouts this financial year, which effectively covers the August and November rate hikes plus one more. Additionally, for the next financial year there will be a further A$9 bn to A$10 bn or so in tax cuts and payments to households.
  • While debt arrears are up, it is from a low base. According to the RBA, less than 20,000 of 5.3 million Australian mortgages are 90 days overdue.
  • Despite a knee-jerk fall following each rate hike or spike in petrol prices, consumer confidence levels remain solid. Weekly auction clearance rates, which provide a timely indicator of consumer confidence and housing market conditions, are well above last year’s levels – despite all the talk of another interest rate hike.
  • Leading indicators are still pointing to reasonable growth ahead. Both the Westpac Leading Index and the National Australia Bank’s business conditions survey are running just above long-run average levels.

  • Manufacturing sector surveys even suggest reasonable conditions despite higher interest rates and strong A$.

Finally, in relation to the current woes in the US housing market, it should be noted that while Australian house prices are extremely overvalued and hence vulnerable to an economic downturn or much higher interest rates, prime mortgages amount to about 93-95% of total mortgages in Australia in contrast to the US where they are about 75%. Also, in Australia there is a major shortage of housing with vacancy rates at record lows. Conversely, in the US there is a massive oversupply with vacancy rates and unsold houses at record levels.
The biggest threat to the Australian outlook is probably a US recession dragging down global growth. However, while the risks have risen, our view remains that the US will manage to muddle through with low growth and avoid a recession due to strength in the corporate and trade sectors. Global growth will remain reasonable, albeit slower than it has been.

The outlook for interest rates
We are hopeful that 6.75% will mark the top for the cash rate given uncertainty about the US economy, the de-facto additional monetary tightening flowing from the credit squeeze and as the strong A$ helps keep inflation down. However, the risks are all on the upside with the hawkish tone of the RBA’s statement announcing the latest rate hike and signalling it will retain a tightening bias. February will be the next RBA meeting to watch. If inflation again surprises on the upside in the December quarter (figures released in January), then another rate hike is likely in February.

Share market outlook
Australian shares have had a remarkable rebound from the low in mid-August, rising nearly 25%. This has taken the market into the top half of its fair value range (as evident in the chart below) and pushed the forward price to earnings ration (PE) up to 16 times which is just above its 10-year average of 15.3 times.

After such a strong run, shares are due for a short-term correction. Certainly, the latest round of US sub-prime related worries, the spike in oil prices, local interest rates worries, the impact of the strong A$ and the risk of another correction in Chinese shares are all significant short-term risk factors for Australian shares.
However, any correction is likely to be shallow compared to the falls into mid-August. While the local share market is no longer cheap, it is not expensive either. The current forward PE of 15.7 is well below the 1999 high of 18.3 times. On top of this, further cuts to US interest rates will provide a strong boost to share markets and growth in China and Asia is likely to remain strong - all of which will benefit Australian shares.

Our view remains that we have now entered a more mature phase in the cyclical bull market in shares that will see slowing profit growth but rising price to earnings multiples driven by lower US interest rates and rising investor exuberance for key investment themes, such as China related plays like resources. As neither valuations nor investor sentiment are at bull market extremes, the trend in shares is likely to remain up. However, volatility will remain high given the uncertainty about the US economic outlook.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors

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